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How healthy are you financially? These two statements provide answers

Together with a balance sheet, two other financial statements can help you determine your financial health. Here’s how to understand them.

By Myriah Johnson

There are three financial statements that are helpful in determining the overall status of your operation — your balance sheet, the cash flow statement, and the income and expense statement. Let’s look at the last two.

Income and expenses

Most simply, the income statement is a summary of revenue and expenses over time. The time interval will depend on the entity, but it can be from one month to one year.

Due to the annual nature of activities, most agricultural operations put together their income and expense statement on a yearly basis. Think of the income and expense statement as telling the story of what occurred throughout the year, while the balance sheet is a snapshot at the beginning and the end.

The income and expense statement can be compiled using the cash or accrual method. Most frequently, the cash method is used because of its simplicity. However, the cash method can tell you the wrong story, unless you manage inventory and accounts payable and receivables very consistently over time.

The main difference between the two methods is the time period in which the income and expenses are recognized and recorded. The cash method is simple, while the accrual method allows you to match income to the expense incurred to produce it.

In other words, the cash method only considers cash transactions, such as selling grain or cattle, or paying for inputs the operation used. Sometimes a crop of grain or calves can be produced, the inputs paid for, and the grain or calves still be in inventory at the end of the accounting period.

In this scenario, a cash-method income statement would report much higher expenses than revenue. Oftentimes, in managing taxable income, a farmer or rancher may pay expenses ahead, defer accounts receivable, sell only a portion of grain or calves — or sell none at all. If these practices are not accounted for through accrual adjustments, the true story is not being told.

Therefore, if accounts payable and receivables and inventories change considerably from the end of one accounting period to another, it would be best to complete the income statement using the accrual method. This will allow accurate evaluation of the operation’s profitability, as well as other things like operating profit margin ratios, rate of return on assets and rate of return on equity.

Cash flow

Unlike the income and expense statement, the statement of cash flows contains all cash flows — not just revenue and expenses. Cash inflows may include things such as cash from the sale of capital items and proceeds from new loans, while cash outflows can encompass things like principal payments on debt and full cost of new capital assets. This statement reconciles changes in cash from one balance sheet to another.

From the statement of cash flows, you can better understand the repayment capacity — or ability to repay term debts on time — of your business. Some of the ratios that help inform in this area are the replacement margin and the capital debt repayment capacity.

While each of the financial statements is a useful tool on its own, together they provide powerful knowledge. Additional ratios regarding financial efficiency can be calculated using information from all the financial statements.

These include the asset-turnover rate, operating expense, depreciation expense, interest expense and net farm income ratios. Collectively, all this information helps highlight areas of strength and vulnerability. In fact, they may just help us keep our operations out of the ditch.

Johnson is an agricultural economics consultant with the Noble Research Institute, Ardmore, Okla.

TAGS: Management
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